If you buy and sell stocks for a profit, then you have to be aware of how stock profits are taxed. This is where long-term and short-term capital gains come into the conversation.
The Stock Trading Craze
Since the beginning of the Pandemic, we’ve seen an increase of new investors jumping into the stock market. Thanks to the popularity of stock apps like Robinhood and WeBull. These companies have made investing more accessible than ever before. With the introduction of commission-free trading and the ability to buy fractional shares.
Investing has never been more popular. But that does come capital gains tax and if you’ve never heard of it before. Then I can see how it could be a little bit concerning. So let’s break it down.
What is Capital Gains Tax
Capital Gains is a term used when you sell an asset for more than you originally paid for it. These assets include stocks, bonds, real estate, even collectibles, and art. I want to make it clear that you will only be taxed on the profit you made on the sale. But the kicker is that this tax is only based on the total profit made at the end of the year, not after every individual sale.
How to Calculate Capital Gains
Let’s say you buy stock XYZ at $100 and then sell it at $120. You just made a $20 profit and will only be taxed on the $20 gain, not the $100 that you initially put in.
On the flip side, let’s say you don’t sell the stock and it grew from $100 to $120. Since you’re still holding on to it and haven’t sold it, you don’t owe any taxes. Because like I said, you will only be taxed when you sell your investments.
What is Short-Term Capital Gains
It depends on how long you hold an asset that will determine if your investment gains are taxed as short-term or long-term capital gains. Short Term Capital Gains are classified under the rule that you bought and sold your investment within a 12-month window. This is common in day trading, where you’re quickly flipping stocks for a profit. At this point, your profit will be taxed at your regular “ordinary” tax rate. Which is the same tax rate as the money you earned from working at your job.
Why is it bad to get taxed Short-Term Capital Gains?
If you earned $40K from your day job and made an extra $10K in stock trading profits. Then you will be taxed as if you earned $50k a year. This is a great way to make extra income. The media always makes short-term capital gains and earned income as the worst way to make money. But the truth is, money is money regardless of how you get taxed. A lot of internet trolls want to make people feel bad about how stock profits are taxed but don’t bash a pay raise or a bonus.
In the USA our tax code is progressive. Meaning that only the extra income that you’ve made could be bumped up to the next tax bracket if you’re close to it. For example in 2022, if you’re single and you made a total of $50K. The first $10,275 will be taxed at 10%, the amount above $10,275 to $41,775 will be taxed at 12%, and the remaining of your income will be taxed at the next tax bracket of 22%.
What is Long-Term Capital Gains
Long-Term Capital Gains are classified under the rule that you bought and held your investments for more than 12 months before you sold them. Because of this, the government is going to offer you a more favorable tax rate compared to short-term capital gains. The reason behind this is that the government wants to promote more long-term investments versus short-term “day” trading. So when it comes to taxes, depending on your tax filing status and how much you pull from your investments. You can expect to pay either 0%,15%, or 20% in taxes on the growth of your investments.
Why is it best to get taxed Long-Term Capital Gains?
When it comes to the preferred tax treatment for stock profits, long-term capital gains come for the gold. If you hold an investment for more than 12 months you’ll now get the benefit of being taxed at a much lower rate. Let’s say you are retiring early and are pulling $50K from your stock portfolio that you’ve held for over 12 months. In 2022, if you’re single, you will be taxed 0% off your profits up to $41,675. The remainder of your portfolio gains that you’ll pull will be taxed at a 15% tax rate, up to $459,750. This is a big tax benefit that a lot of people unfortunately overlook and why this is the most favorable capital gain tax.
Tax Forms
Before you file your taxes for the year, please know that all brokerage companies are required by law to provide you with a form 1099 to file with your taxes. This is where you will see your total Capital Gains and losses for the year. If you want to see your rolling tally of your capital gains, you’ll have to go to your brokerage company online portal somewhere under tax forms and information.
I know I didn’t go over capital losses in this blog but know that you can offset your gains with losses at the end of the year.
Closing Thoughts
The one thing you need to consistently be aware of new laws and lawmakers who challenge capital gains taxes. Every year the IRS updated income limits for your income taxes and for capital gain taxes as well. Being aware that these numbers can change each year can make a big difference in how you approach your finances. I personally am a big fan of long-term investing, which benefits most of the long-term capital gains tax. Regardless of your investing style, taxes will always be something you have to deal with if you’re investing outside of a Roth IRA.
Additional Resources
- 2021-2022 Long-Term Capital Gains Tax Rates – BankRate.com
- How much you can make and not pay capital gains tax -CNBC
- IRS Free File: Do your taxes for free -IRS.gov
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- What I Wish I Knew About Investing in My 20’s
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- Should You Invest Your Savings?
